Derivatives
What this domain tests
Derivatives derive value from an underlying asset. You must distinguish the four core types and their uses. Forwards are private, customised, OTC contracts with counterparty risk. Futures are standardised, exchange-traded, cleared, margined contracts. Options give the buyer a right (not obligation) to buy (call) or sell (put) at a strike price, for which the buyer pays a premium. Swaps exchange cash flows, most commonly fixed for floating interest (an interest-rate swap).
Concepts to master
- Hedging versus speculation: hedging reduces existing risk; speculation takes on risk for potential return.
- Payoff profiles: a call buyer profits when the underlying rises above strike plus premium; a put buyer profits when it falls below strike minus premium.
- Margin: initial and variation margin on futures; daily mark-to-market; the role of the clearing house.
- Counterparty and credit risk: OTC forwards and swaps carry it; exchange-traded futures largely mitigate it via central clearing.
- Gearing/leverage and the resulting magnified gains and losses.
Traps
Do not confuse the buyer (holder, who pays premium and has the right) with the writer (seller, who receives premium and has the obligation). Remember a forward is an obligation for both parties, unlike an option. Questions often test that futures are standardised and margined while forwards are bespoke.
Rule of thumb
Buyer of an option = right, no obligation, pays premium; writer = obligation, receives premium. If the question says "may choose not to exercise", it is an option.
Worked example: An investor buys a call with a £2 strike for a £0.50 premium. At expiry the underlying is £3. Intrinsic value = £3 − £2 = £1. Profit = £1 − £0.50 = £0.50 per share. If the underlying is £1.80, the option expires worthless and the loss is the £0.50 premium.